[T.S.R:11672] Check if debt could do them apart

http://www.thehindubusinessline.com/bline/iw/2009/11/22/stories/2009112250701400.htm

Debt can be a double-edged sword. It is imperative to make a proper
and continual assessment of the debt-servicing abilities of companies.

Anand Kalyanaraman

Debt has attained a hallowed status in the world of finance and evokes
myriad reactions, with some using it liberally to set up, run and
expand business, even as the conservative assiduously avoid it.

Debt can be a double-edged sword. Its positives include being able to
raise capital without diluting control and improving return on equity
by generating returns greater than interest cost. On the other hand,
debt can be a millstone when the going gets tough. Regardless of
profitability, companies need to service debt.

This can aggravate already weakened financials in tough times, and may
entangle businesses in debt traps. In extreme cases, inability to meet
debt obligations may lead to bankruptcy.

Hence, it is imperative for lenders and investors to make a proper and
continual assessment of the debt servicing abilities of companies. Key
indicators of debt to watch out for include changes in debt level, and
financial leverage ratios.
Debt levels

Firms such as Infosys which have been conservative in their borrowing
philosophy have remained zero-debt for several years. On the other
hand, several firms lean heavily on debt.

While a sharp increase in debt within a relatively short period could
be indicative of deteriorating business conditions (for example, Air
India), this need not always be the case. Reliance Industries, for
example, also increased borrowings substantially over the past few
years; yet continues to be in good health. Hence, changes in debt
level need to be considered along with other financial parameters. For
instance, a strong cash position provides comfort about the company's
ability to meet debt obligations. The net debt measure (debt minus
cash) is a good indicator in this regard. Also, financial leverage
ratios provide a fair assessment of the risk entailed by debt.
Financial leverage ratios

Financial leverage ratios, also known as gearing ratios, measure the
extent of debt in the capital structure and the company's ability to
meet its debt service obligations. Favourable ratios provide comfort
to stakeholders and also give companies leeway to raise new debt,
which can be quite helpful, especially in tough times.

Leverage ratios which throw light on capital structure include debt/
equity, debt/capital and debt/assets. These ratios measure the
proportion of debt to various balance-sheet denominators, with low
metrics indicating lesser dependence on borrowing. Optimum ratios
depend on the sectors companies operate in, with capital-intensive
companies tending to rely more on debt than service-oriented ones.

By far, debt/equity, which measures the proportion of borrowed funds
to owner contributed capital, is most widely quoted, with a metric
above 2 generally considered to be a sign of overleveraging. To put
this in perspective, Air India's debt/equity as of June 2009 was a
staggering 105, while that of Reliance Industries, as of March 2009,
was a reasonable 0.64.

Debt servicing ability is reflected in ratios such as interest
coverage (EBIT/interest expense) and debt/EBITDA. Interest coverage,
also known as times interest earned, measures the number of times
operating earnings can pay interest cost. Higher the ratio, better the
comfort level in the company's ability to meet its interest payment
obligations. An interest cover below 2 is generally considered to be a
red flag.

Debt/EBITDA, a broad measure of debt servicing ability, gives an
indication of the payback period for the debt liability using cash
earnings, with a low metric translating into lesser risk.

For banks and other firms whose business is predicated upon borrowing
and lending of money, traditional financial leverage ratios may not
reflect the correct picture.

In such cases, relevant ratios to assess financial leverage include
the capital adequacy ratio (CAR). This ratio essentially measures the
proportion of advances to customers required to be financed by a
bank's equity and similar long-term capital. The RBI currently
mandates banks in India to maintain CAR of minimum 9 percent.
Other factors to consider

Assessment of debt also includes knowing about the interest cost,
maturity profile and terms of borrowings. Companies saddled with high-
interest bearing debt in a falling interest rate regime would be in a
negative position. Also, large quantum of debt maturing in the short
term would necessitate maintenance of adequate resources to meet
obligations.

Terms of borrowing, known as covenants, include restrictions placed on
the company by lenders in the form of do's and don'ts.

Also, it is important to take note of special forms of debt such as
convertibles in the balance-sheet. These instruments, also known as
hybrids, give lenders the option to convert the debt into equity at a
predetermined price on a later date.

Though conversion will dilute equity, it will help reduce the debt
liability of companies. On the other hand, debt which is not converted
due to decline in share price below the predetermined price will
necessitate the company to continue servicing the debt.

Credit ratings issued by rating agencies are also helpful in assessing
the debt profile of borrowing companies.

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